Next, it is customary to assume that the difference between the expected rate of

Question

Next, it is customary to assume that the difference between the expected rate of return on the “market portfolio” and the risk-free rate of return is about 7.0%. This is the expression [RM - RF]. So, if for example, the risk-free rate of interest is, say, 3% per year, than the expected rate of return on the “market portfolio,” RM, is 10%. So, multiply the “beta” of your SLP Company by 7.0%. That will be the equivalent of your company's ßj [RM - RF]. Then add to that number the current yield to maturity on a US Government bond [see step (1) above]. You are free to try to research and find more up to date values of RM and RF, but to simplify this assignment you can also assume that RF = 3, RM =10 and [RM - RF]= 7.

The above procedure provides you with an estimate of the rate of return that the shareholders of your SLP Company require on their investment. This rate is called the cost of equity of your company.

After going through these calculations, write a two to three page paper with the following information:

1) Show your work that you used to obtain the cost of equity for your SLP company.

2) Is this cost of equity higher or lower than you expected? The average cost of capital for a firm in the S&P 500 is 10.2 percent. Would you think your firm should have a lower or a higher cost of capital than the average firm?

3) Look up the betas for some of the other companies that you compared your SLP company to for your Module 2 SLP. These are the companies that you had to explain had a higher or lower discount rate than your SLP company. Using these betas, compute the cost of equity for these firms. How do they compare to your SLP company? Are you surprised that some firms have a higher or lower cost of equity than your SLP company?

4) How would you go about finding the cost of equity using the dividend growth model or the arbitrage pricing theory for your SLP company? Don't worry, you don't actually have to do any calculations - just explain how you would go about doing these calculations and explain what kind of additional information you might need.

Explanation / Answer

1.    Take the beta value for SLP company is 1.2. Then cost of equity is                Cost of equity      = RF + (RM-RF)+beta                Here RF   = 3% , RM = 10%, Beta = 1.2                Cost of equity      =3% + (10%-3%)%1.2                                          =3% + 7%*1.2                                          =3% + 8.4%                                          =11.4%       Therefore cost of equity is 11.4%. 2.       The expected return is 12.5%. Then then the cost of equity is lower than the expected return.       And the Cost of equity is higer than the average cost of capital.                Yes every firms should have higer cost of equity than the average cost of equty. Because to reach the share holders expectations. 3.           For example company 1 has beta of 1.5 and company has beta of 0.5. Then cost of equity for these two companies will be as follows. For company 1:          Cost of equity      = 3% + (10% -3%) *1.5                                    =3% + 7%*1.5                                    =13.5% For compay 2:       Cost of equity         = 3% + (10%-3%)*0.5                                    =3% + 3.5%                                    =6.5%       Form the above, we can say that company has higher cost of equity than the SLP company.       Company 2 has lower cost of equity to SLP company. 4. `   The estimation Cost of equity using dividend growth model is         Cost of equity       = Dividend(1+growth rate)/Current market price of the share + growth rate        By using the all the above date we can find out the cost of equity.         

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